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Study Cautions Institutional Investors on Portfolio Diversification

 

March 31 - In a new publication titled “Improved Risk Reporting with Factor-Based Diversification Measures,” EDHEC-Risk Institute encourages institutional investors to look carefully at the effectiveness of their portfolio diversification. CACEIS supports the research chair on “New Frontiers in Risk Assessment and Performance Reporting” in which this research was produced.

Before the financial crisis, pension funds were insufficiently diversified, with concentration in a small number of asset categories, said research authors. Since the crisis of 2007, there has been a genuine trend towards investment in new asset classes and categories in order to diversify, but that does not mean that the diversification is effective.

The study examined the 1,000 largest U.S. pension funds as of Sept. 30, 2002, Sept. 30, 2007, and Sept. 30, 2012.

 The research introduces new diversification measures based on the concept of risk allocation rather than the concept of asset allocation. The authors’ aim was to measure the correspondence between the appearance of diversification (the effective number of classes or constituents, or ENC) and the reality of diversification (the effective number of bets, or ENB), which measures the actual number of independent risky bets taken by institutional investors. Risk-adjusted performance is measured more effectively by using ENB.

Increasing the number of asset classes or categories without taking the inter-relations between their risks into account does not provide any real gain in terms, first, of diversification, and then of performance.

A copy of “Improved Risk Reporting with Factor-Based Diversification Measures” can be downloaded via the following link: EDHEC Publication Improved Risk Reporting with Factor-Based Diversification Measures.


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